Colorado Real Estate Journal - May 4, 2016
Cost containment and cost certainty are two of the most important issues for construction project owners. Owners need to know as accurately as possible how much a project will cost before the project starts and they need to control costs during the project. On most projects, owners achieve those goals in the preconstruction phase by obtaining competitive, fixed-price bids or requiring a guaranteed maximum price. When projects need to be fast-tracked or they involve enough potential uncertainty that contractors have difficulty arriving at a fixed bid or guaranteed maximum price, the best option is often a cost-plus contract with an agreed upon fee and no GMP. Under a cost-plus contract, the owner agrees to pay all reasonable and necessary costs the contractor incurs to build the project – subcontractor costs, materials, reasonable general conditions, etc. – plus a fee. The fee is typically calculated as a percentage of the project costs, and the exact percentage can vary widely depending on the circumstances. The problem with cost-plus contracts for owners is they shift almost the entire risk of cost increases to the owner. And since the contractor’s fee is a percentage of project costs, the contractor has an incentive to drive up costs to increase its profit. Despite the allocation of risk, cost-plus contracts do not give contractors the right to incur costs with wild abandon. A well-drafted cost-plus contract will contain measures to keep costs under control. Outside of the contract, the law imposes duties on contractors to keep them from running up project costs at the owner’s expense. Some jurisdictions go so far as to impose fiduciary duties on contractors working under cost-plus contracts, but even where contractors are not fiduciaries, courts require them to take steps to control costs. The first duty courts impose on contractors is to keep costs reasonable. This means the contractor should only incur costs necessary to complete the job in a competent manner. The contractor must, therefore, take measure to control its costs. The contractor also bears the risk of costs arising out if its own defective or inefficient work. Such costs may not be passed on to the owner. The second duty placed on contractors is to inform the owner of cost overruns. Conditions change during construction all the time and for many different reasons. Owners should reasonably expect changes, but they cannot make informed decisions about how to handle changes unless the contractor informs of the change and its effect on project costs in advance. Colorado courts have held that a contractor who fails to keep owners apprised of cost overruns is acting in bad faith. Both owners and contractors need to carefully manage costplus projects to keep costs reasonable. This starts with the contract. The parties should outline their expectations as clearly as possible and include provisions to control costs, such as the following: • All costs must be reasonable and necessary. Although the law imposes this requirement anyway, making it explicit in the contract will help the parties and, if necessary, a court, know what is required. • Require an initial estimate prior to executing the contract. Circumstances may make a fixed-price bid impractical, but a competent general contractor should be able to provide a base estimate with the understanding that changes to the design, unforeseen conditions, owner-initiated changes and other factors may increase the cost. • Where possible, require the general contractor to obtain competitive bids from subcontractors. Again, this may be difficult for some trades to do, but most should be able to provide a base bid with the understanding that changes may occur. If a sub is absolutely unable to estimate the cost of its scope of work, the general contractor should include an allowance in the estimate and inform the owner. • Provide for a change order process. Change orders, when handled properly, are an effective measure for keeping the owner informed and addressing cost increases before they become a problem. The change order provision should require the contractor to submit a written change order that outlines the proposed change and tell the owner what it will cost. It should also require the owner agree to the cost in writing before the contractor does the work. • Require the contractor to submit an updated schedule of values with each pay application. This will keep the owner apprised of changes to the base estimate as the project progresses. The owner can see where the costs have increased and by how much and can make informed decision about the project moving forward. • Define what should be included with each pay application. The pay applications should provide backup for the costs billed. This includes time cards documenting the work the GC’s employees and those of its subcontractors performed as well as invoices for materials used in the project. • Put the hourly rates for the contractor’s management and supervisory personnel in the contract. • Include a provision that allows the owner to audit the project costs after reasonable notice. As with any relationship, the key to a successful costplus contractual relationship is communication. If the contractor keeps the owner informed, and the owner is diligent is monitoring costs and raising concerns with the contractor during construction, a costplus arrangement can work well. When communication breaks down and costs overruns occur, no one is happy and the parties are much more likely to end up in a costly dispute. Proper communication, including carefully documenting what happens during construction, will protect both the owner and the contractor.